Equity Collar/Fence

[Marc100]

The following trades were placed using CFD's and Options through a spread bet company.

Yesterday I closed a trade that probably shows my inexperience. Although, in hindsight, I have some idea as to why the strategy went the way it did I would appreciate the opinions of those with greater experience than myself.

I purchased some equity four weeks ago. Two weeks later the share price rose significantly so I placed a Fence around the current price to lock in my gains .
I bought 1 put below my current price (at 70) and sold a call (at 80)above, both expired in September. My understanding was that my upside would be capped at the strike price of the call (80) and my downside protected at the strike price of the put, 70.

I mistakenly believed the spread for the options wouldn't rise significantly whilst the share price remained within the two strikes, I thought the price of one would counteract the other.
The original spread was 2.75. When I tried to close the position the broker quoted me 6.5. The broker was trying to close the position by individually removing the options. As I have some options knowledge I was able to point out that he had to remove the trade as a strategy, luckily he accepted my arguement and removed the strategy at half his original quote, 3.25.

I need clarity on the following points:

1) I closed the entire position when the share price hit 79. Should I have waited until it went above 80? Would it have made a huge difference. What is the ideal time to close the collar?

2) When I sold the equity position the broker told me I basically had a naked short position. Is that right? I believed one option was off setting the other.

3) I appreciate the adverse affects of time value on the price of my options but I thought one options time value would mitigate the other's. Why wasn't this the case?

4) Similiarly. When I entered the trade the implied volatility was very high, 60%+. Again I thought the sold option would mitigate the adverse affects of buying an option when IV was high. Why wasn't this the case?

5) Do you believe the broker acted unethically when he quoted me the 6.5 spread?

I should point out that this wasn't a losing trade, I just didn't make the percentage gain I had calculated. If I had accepted the broker's original quote's I wouldn't have benefitted at all from a 13% rise in the share price.

Apologies for the length of the post. Any answers greatly appreciated.

Kind regards

Marcus.

 

[oatman]

Surely if you sold a call you're wide open.

 

[RogerM]

A number of interesting points here.

1) I closed the entire position when the share price hit 79. Should I have waited until it went above 80? Would it have made a huge difference. What is the ideal time to close the collar?


The maximum profit would be at 80. Assuming that you have sold the same number of calls as you have shares/cfd's (normally 1 option to 1000 shares/cfd's in the UK), then above 80 for each point the shares go up the price of the option at expiry will also rise by 1 point, and which you therefore have to pay to buy it back. Therefore profit plateaus off at 80.

2) When I sold the equity position the broker told me I basically had a naked short position. Is that right? I believed one option was off setting the other.

Your broker was correct. Whilst you hold the CFD, you have a covered call. As mentioned above, for every point that the short call option goes into the money it will be covered by the gain in the value of the cfd. Remember that a short call, once it is in-the-money, will be exercised by the holder at expiry and you will have to deliver shares at the strike price - in this case 80. Whilst you hold the shares this is not a problem. Once the cfd is sold there is no cover for the option. So if (say) there is a takeover bid at 100, the only way you can deliver the shares is to buy them in the market at the market price, in this case 100, and then deliver them to the purchaser of your call option at the strike price - in this case 80. For this reason I would very rarely hold a naked short call for a share. I regularly hold short calls on the ftse 100 index as there can't be takeover bid on the index.

3) I appreciate the adverse affects of time value on the price of my options but I thought one options time value would mitigate the other's. Why wasn't this the case?

It is all down to the delta of the 2 sides of the position. Time value will only balance out when the deltas are the same. This will be approximately when each are the same amount out of the money, in this case 75. As the price rises the delta of the call will rise as it goes into-the-money, whilst that of the put will fall. So the price of the call will rise faster than that of the put will fall. The reverse is true if the share price was to fall - i.e. the price of the put will rise faster than the price of the call falls.

4) Similarly. When I entered the trade the implied volatility was very high, 60%+. Again I thought the sold option would mitigate the adverse affects of buying an option when IV was high. Why wasn't this the case?

The answer is very similar to that above. If you have equal numbers of long and short positions - in this case you had 1 short call and 1 long put - the effects of IV should balance out provided that the delta's are the same. If deltas are different, and they will be if the share price has risen to the strike price of the call, then they will no longer balance. IV tends to be higher the nearer the price is to the money. Also remember that as you get closer to expiry, Gamma (the rate at which delta changes for each point change in the underlying share) also rises. This is logical if you think about it. With less time to expiry there is less chance that an out of the money option will go into the money, and less chance for an in the money option to go out of the money, so as expiry approaches the time value for an out of the money option collapses. Very low time value leads to very low IV. So close to expiry your at-the-money call will still have significant time value because there is a high chance that it will expire in-the-money and have some intrinsic value. On the other hand the put is now deep out of the money and close to expiry will have very low time value because the chances are it will expire without value.


5) Do you believe the broker acted unethically when he quoted me the 6.5 spread?

Sounds a bit steep, but as you say, if you wanted to close the strategy the spread would be lower.

Typically a cap and collar is a useful strategy to protect a position whilst your eye is off the ball - say whilst on holiday. On your return you can leg out of the position - in other words selectively close elements of it. In this case with a price rising I would consider selling the puts early to retrieve some of the premium remaining in the time value. I would retain the short calls and accept that my profit would be capped at 80. If price doesn't get to 80 then the calls will expire worthless and you get to keep all the premium. If price rises above 80 and you want to keep the shares, then buy back the calls at expiry and pay for them by selling an equal number of calls at a higher strike price, say 90, in a later month. This is known as "rolling out". At some stage there will usually be a pullback and you can either buy back the calls at a lower price or just let them expire worthless.

If you want to sell the shares when the price reaches the strike price of the short calls, you can either buy back the calls or hold on to them and take the risk that the share price continues to rise and the calls go into-the-money. Could be expensive if there is a take-over bid. If you want to hold on, at least consider buying a cheap out-of-the-money call to cap possible losses.

HTH

 

[Marc100]

Thank you!

RogerM

I spent most of yesterday analysing my trade.
Although I basically understood the elements that affected my trade I was unable to structure those thoughts in a logical manner. Thankfully for me your answer has cleared up my confused state so now I have a far better understanding of the components that make up a collar.

Many, many thanks.